Major Shift in Lending Parameters

Nic Green & Brian Jagger, Citifund Capital Corp.
March 2008

The mortgage market has been abnormally volatile in recent months. The consequences of the sub-prime mortgage issue and the ensuing collapse of the asset backed securities market have negatively impacted the supply of Canada’s mortgage market. Supply has shrunk and the spread over bond yields has increased.

At a recent lecture at Queen’s University, Reiner Plessl (director at RBC Dominion Securities Real Estate) said that borrowers who find acceptable financing for their commercial properties should take advantage of it as quickly and as early in the year as possible. He believes that most Canadian Banks will exhaust their commercial mortgage funds by August.1 It is estimated that the mortgage debt market of approximately $15 billion dollars nationwide in 2007 will be reduced by $3 – 4 billion (20% – 27% of the market) as CMBS issuers (conduit lenders such as Merrill Lynch, Column Canada, etc.) withdraw from providing commercial mortgage financing. According to many lenders, life companies & pensions funds are not expected to increase their lending programs to compensate for this decrease in available funds and in some cases, they have had their insured mortgage allocations cut by 20% to 50%.

The decrease in supply of funds has caused the process of commercial financing to become noticeably more arduous. Over the last several months, the spread lenders charge over bond yields has increased. On 5 year CMHC insured loans, the spreads have risen from .45% to .95%+. Uninsured commercial loan spreads for 5-year term placements have risen from 100 basis points to 180+. What has been of particular note, is the wide disparity in rates being quoted by the lending community. Late last year, it was common for rates quoted by various tier 1 lenders, to be within 5 – 10 basis points of each other. We are now seeing rate differentials of 20 – 30 basis points. It is clear that borrowers will serve themselves well by having wide access to the lending markets to ensure the best rate is obtained. Property owners are well aware of the positive effect on the value of their rental properties that a low rate mortgage can have. This positive effect increases, of course, as the term of the loan becomes longer.

The typical loan underwriting parameters employ a “Debt Service Coverage Ratio” test and it is this formula that is the restrictive component in maximizing the loan amount for a particular property. A lender may be prepared to lend 75% or more of the value but the DSC ratio effectively caps the loan amount based on cash flow. It becomes obvious that the lower the rate, the greater leverage a borrower can obtain. In this current low cap rate apartment market environment, buyers are required to put in relatively high levels of equity and selecting the right lender and loan terms can make a significant difference in minimizing the cash equity to be injected.

While we have focused on the widening spreads in the current mortgage market, there is a silver lining. As the US economy grinds through its economic slowdown, bond yields have been dropping. 5-year bonds at around 4.4% in October 2007 have given way to current yields in the sub 3% range. The net effect is that, even with widening spreads, interest rates available today are relatively low for quality properties that can attract financing. Gone are the days of calling one’s favorite lender and being confident that they can provide a loan close to the best terms available. With the vast number of different options open to a borrower today, ensuring wide and deep access to the institutional lending market has never been more important.

Nic Green & Brian Jagger, Citifund Capital Corp.,
(604) 694-2726